Monday, October 27, 2008

Deflation and Liberty

Jörg Guido Hülsmann wrote an incredible essay called Deflation and Liberty (HT Vijay). It is one of the best explanations of inflation and deflation I've ever read and it is a must read for anybody who really wants to understand the monetary background for the credit crisis along with the political implications.

Why is understanding inflation and deflations so important? I'd say there's no topic more important in order to understand the current economic and political landscape. And if you are an investor, this is critical background information.

We've lived in a world of monterary inflation for decades. In fact, we experienced exponential growth in the money supply courtesy of the Federal Reserve and the banking system (and most recently, the shadow banking system). Like most exponential processes, it come to an end. And that's what we're seeing right now. The unwinding of leverage and destruction of credit is causing all that inflation to run in reverse. This is having an enormous structural impact on our financial system. We depended on an ever increasing amount of money to pay back an ever increasing amount of debt. Since in our monterary system, money is nothing more than debt, this means we depended on an ever increasing amount of new debt to service our existing debt. Now that new debt issuance is decreasing, there is no way for the existing debt to be paid back. This is the reason why defaults are widespread. There will never be enough money to pay back the existing debt and most of the creditors are not going to get their money back. This is why there is a mad dash for cash and safe havens. It's like musical chairs where at best there are half as many chairs as people. And it may even be as few as one tenth the number of chairs as people. Of course, the government is doing its best to "print" new chairs as quickly as it can.

The inflationary regime had enormous benefits to the government, the banking system, and the businesses that were the recipients of the newly-created money. The government needed inflation to finance its budget deficits and pay back its debts with future debased dollars. The banking system benefited from inflation because it was the conduit by which all that debt was created and serviced and it allowed banks to borrow short at low interest rates and lend long at higher interest rates. The businesses that most benefited were the ones that were the biggest beneficiaries of government lagresse. For example, the military-industrial complex, the universities that depended on government grants and loans, the farmers who received subsidies, and the healthcare sectors that benefited from medicare and medicaid. And most importantly, the politicians who depended on promising new spending for special interests without having to raise taxes. The people that were most hurt by this were those furthest from Wall Street and the companies that were part of the welfare-warfare state. The average worker saw his income barely able to keep up with the inflation in the economy. Instead of one parent working, both had to work in order to maintain the same lifestyle. It encouraged the average person to borrow instead of save because negative real interest rates punished saving and rewarded borrowing. Instead of being able to buy a house with savings, Americans had to take on mortgages they couldn't afford and become debt slaves. This was the outcome of the inflationary regime.

Hülsmann writes

In short, the true crux of deflation is that it does not hide the redistribution going hand in hand with changes in the quantity of money. It entails visible misery for many people, to the benefit of equally visible winners. This starkly contrasts with inflation, which creates anonymous winners at the expense of anonymous losers. Both deflation and inflation are, from the point of view we have so far espoused, zero-sum games. But inflation is a secret rip-off and thus the perfect vehicle for the exploitation of a population through its (false) elites, whereas deflation means open redistribution through bankruptcy according to the law.

And this is why the government will do everything in its power to prevent deflation. The government itself depends on inflation to finance its own operations. The financial system is being destroyed by the asset deflation we're currently witnessing. The government is on borowed time for how long it can keep financing all its spending under the deflationary spiral. And if there's any doubt that the government will do everything in its power to prevent deflation: there's a reason why Bernanke is the Federal Reserve Chair. He gave a speech in 2002 called Deflation: Making Sure "It" Doesn't Happen Here. This is where he famously said that the Federal Reserve had printing presses and could drop money from hellicopters.

A deflation just fundamentally changes how one has to think about money and assets. Somebody said to me today that he was dissapointed he could only get about 3% yield on a 6 month CD. And I responded that he should consider this an amazing yield in these times. Even if he broke even in dollars, he should consider how much more valuable his dollars are worth today than they were just one year ago. If he converted his dollars to some other "currency" units like the DOW, the S&P, or houses, he could buy a lot more of each than he could in the past. Savers were punished under an inflationary regime but they are rewarded magnificently during deflation. Anybody who had the foresight to see this coming and moved their assets to cash is doing very well.

But again, one must consider tha the government will do everything in its power to stop the delfation. I suspect that if all these alphabet soup programs the FED and the Treasury have started don't work, the government will just start confiscating wealth directly. In Argentina, the goverment recently confiscated private pension funds. The Democratic leadership has already proposed doing the same here. I wouldn't be surprised if this happens under an Obama administration. Sorryto those of you who have 401(k)s and IRAs -- the government wants to increase aggregate consumption and you savers are making that harder.

I am reminded of a couple quotes. The great Austrian economist Ludwig von Mises said

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

In other words, we're either going to have deflation or the destruction of the dollar. Maybe through some miracle the Fed will be able to reinflate the economy without destroying the currency. The Japanese tried this and failed. They lowered interest rates to 0% and then started printing money. They were still unable to stop delfation and they had decades of negative or negligible growth. In fact, their stock market recently hit a 26 year low.

The Hülsmann essay explains why we shouldn't fear deflation. It's necessary to repair all the distortions of the past inflation. And it's like I've said before, we have way too many real estate agents, construction workers, bankers, and bomb makers. We need more teachers, doctors, nurses, and medical technicians. This deflation is the opportunity to realign our workforce around where the real market demand lies.

The other quote I am reminded of is one from Thomas Jefferson:

If the American people ever allow private banks to control the issuance of their currency, first by inflation and then by deflation, the banks and corporations that will grow up around them will deprive the people of all their property until their children will wake up homeless on the continent their fathers conquered.

Until recently, I understood the inflation part, but I didn't understand the deflation part of his quote. It was obvious how inflation redistributes wealth and makes people poorer. But now I see how the deflation is transfering so many people's homes to the banks. People are likely to blame this on the crash, but the crash is the inevitable result of the bubble. The perverse part is that now we're using tax-payer money to recapitalize the banks. These banks will survive because of we won't let them fail and the result will be that they will end up owning a huge percentage of the homes in the country. Maybe that's what Jefferson had in mind. He anticipated that a central bank at the head of a banking cartel would always favor the banking system over the average citizen.